One cannot price effectively without understanding costs. To understand one's costs is not simply to know their amounts. Even the least effective pricers, those who mechanically apply cost-plus formulas, know how much they spend on labor, raw materials, and overhead. Managers who really understand their costs know more than cost levels; they know how their costs will change with the changes in sales that result from pricing decisions.
Not all costs are relevant for every pricing decision. A first step in pricing is to identify the relevant costs: those that actually determine the profit impact of the pricing decision. Our purpose in this section is to set forth the guidelines for identifying the relevant costs once they are measured. In principle, identifying the relevant costs for pricing decisions is actually fairly straightforward. They are the costs that are incremental (not average) and avoidable (not sunk). In practice, identifying costs that meet these criteria can be difficult. Consequently, we will explain each distinction in detail and illustrate it in the context of a practical pricing problem.